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That Sinking Feeling Overseas

After several years of smooth sailing, foreign stock markets are giving investors a bad case of seasickness. Between mid May and mid June, stocks in some developing markets surrendered as much as 30% of their value, and even stable markets in Europe and Japan sustained double-digit percentage losses.

What's roiling the waters? Mostly, it is the actions of central bankers. In the U.S., Standard & Poor's 500-stock index fell about 8% after Federal Reserve chairman Ben Bernanke warned in June that inflation had reached "unwelcome" levels (see Going Long in the August issue) and signaled that the Fed would continue to raise interest rates to rein in inflation. The European Central Bank also raised rates recently, as did its counterparts in several other nations. "People are worried that central banks around the world are going to raise rates too much and kill their economies and earnings," says Alec Young, an SP strategist.

But even though the suddenness and magnitude of the losses have been unsettling, there are at least two good reasons not to abandon foreign stocks.

Diversification

True, as globalization spreads, markets become more synchronized. But they're still different enough to make global diversification worthwhile. By holding some foreign stocks and funds, you trim the risk that all of your stock investments will tank at once. In addition, foreign investments can potentially improve your portfolio's returns -- particularly if the dollar weakens against other currencies -- while reducing its overall risk. SP recommends that you dedicate 20% of your stock investments to foreign issues, with emerging markets accounting for 3% of your portfolio. We think a 3% to 5% allocation is about right.

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Promising outlook

Economic growth is on the rise in Europe and Japan. That's why the European Central Bank raised interest rates twice recently and Japan's central bank is thinking of doing so for the first time in years. The rising rates will put a damper on growth but won't kill it. "Interest rates are not prohibitively high," says Thomas Melendez, manager of MFS International Diversification fund.

The nasty drop in stocks of emerging markets belies improvements in the underlying economies. In the mid 1990s, rising rates exposed fundamental weaknesses in the economies of many of these nations, leading to a global financial crisis. Since then, many have paid down debts and reformed their economic systems. "Today, emerging markets are providing capital to the U.S. to fund its imbalances, rather than the other way around," says Melendez.

Emerging markets, in particular, are prone to boom-and-bust cycles. But the case for holding foreign stocks in your portfolio remains strong. If you're unsure how much to allocate to developing markets, invest in a diversified foreign-stock fund and let its manager make the call. One of our favorites is Dodge & Cox International Stock (symbol DODFX; 800-621-3979), which recently had 14% of assets in emerging markets. If you dare to venture further into exotic lands, we also like SSgA Emerging Markets (SSEMX; 800-647-7327). If you prefer exchange-traded funds, iShares MSCI EAFE Index (EFA) covers developed markets in Europe and Asia, and iShares MSCI Emerging Markets Index (EEM) tracks stocks in developing countries.